What is an “Option”?
An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest.
It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on.
It has an expiration date. When an option expires, it no longer has value and no longer exists.
Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.
Before you begin trading options it’s critical to have a clear idea of what you hope to accomplish. Options can play a variety of roles in different portfolios, and picking a goal narrows the field of appropriate strategies you might choose. For example, you might decide you want more income from the stocks you own. Or maybe you hope to protect the value of your portfolio from a market downturn. No one objective is better than another, just as no one options strategy is better than another – it depends on your goals.
Buying and Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly – so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again.
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless.
For more information on learning the basics and knowing how to start buying and selling options, visit the Learning Center via TradeKing.